Turkey's Economic Rebalancing Becoming More Challenging

The FINANCIAL -- Turkey's progress towards economic rebalancing may become more challenging for the remainder of 2014, despite the success of policy adjustments made earlier in the year, says Fitch Ratings. Monetary policy settings have loosened since May, while the fragile eurozone recovery and heightened geopolitical risk could slow current account adjustment.

Recent data convey mixed messages on rebalancing. Compared to 2013, annual credit growth has virtually halved to 20% according to the Central Bank of the Republic of Turkey's (CBRT) preferred 13-week moving average metric. But the pace of decline has slowed, while further rate cuts could easily reverse the trend. CBRT research shows that the current account is particularly sensitive to credit growth.

Meanwhile, core inflation has remained above 9% since the start of the year, well above both the CBRT's year-end forecast and its medium-term target, according to Fitch Ratings.

Monetary policy settings have eased despite rising inflation. The CBRT held its one-week repo rate at 8.25% at its latest policy meeting, but cut overnight lending rates. Political pressure on the CBRT to cut interest rates shows no sign of easing. Indeed, Fitch Ratings believe such pressure may intensify following this week's 2Q14 GDP release which showed growth slowing to an annual rate of 2.1% from 4.3% on 1Q14.

Economic populism remains a risk ahead of next year's parliamentary elections. However, cabinet appointments since Recep Tayyip Erdogan became president suggest he sees the value of having a credible, experienced economic team in place, and 1H14 budget outcomes suggest fiscal discipline has been maintained.

Like high inflation, high current account deficits (CAD) suggest a predilection for higher growth but without long-term structural reforms that might, for example, raise gross domestic savings rates or improve the business climate, thereby aiding foreign direct investment. Fitch Ratings forecast a slower improvement in the CAD in 2015 to 5.7% of GDP from a forecast 6.2% in 2014, and note that the quality of external financing remains poor, with almost 70% still funded by portfolio and unidentified capital inflows in 1H14.

A high CAD and gross external financing needs are an established credit weakness. Turkey was among the emerging-market sovereigns most vulnerable to a drop in capital inflows in Fitch's recent "shock scenario" where volatility and risk premiums spike as US interest rates rise higher and faster than in our base case, although more recent ECB monetary easing could moderate a shock of this nature.

Turkey has been resilient to external shocks; with the sovereign maintaining external market access, and banks and corporates enjoying high rollover rates. Favourable market access will continue, but the short-term share of gross external debt has doubled since 2007 to 32%, driven largely by bank borrowing. Banks' vulnerability to a more extreme scenario, involving an abrupt and prolonged funding market closure, has therefore increased.

Furthermore, the accumulation of banks' foreign assets in the reserve option mechanism (ROM) implies that gross international reserves may not be wholly under the control of the CBRT, thus serving to limit the authorities' potential room for manoeuvre if there were a full scale external liquidity crisis, according to Fitch Ratings.